Brazil real gets relief from overheating jitters

AnjaliCordeiro

NEW YORK (MarketWatch)-Investors have for months worried that Brazil's red-hot economy was set to overheat, but now those jitters have finally begun to ease.

Surveys show that inflation expectations have come down in the last two weeks as policymakers appeared to take a tougher stand on inflation.

That is setting the stage for a stronger currency and has some prominent firms predicting that the Brazil real will rise beyond its pre-crisis highs to reach BRL1.55 per dollar by year end.

Inflation expectations, as shown in a weekly central bank survey of economists and investors, have fallen over the last two weeks, after rising for a long stretch.

The main reason inflation expectations are moderating "is the hawkish stance of authorities," said Kathryn Rooney Vera, a macroeconomic strategist at Bulltick Capital Markets. "The market realized [interest rates] are going to go higher. That bodes well for the real."

Bulltick expects Brazil's key SELIC interest rate to go to 12.75% by year's end from the current 12% level. Rooney points in particular to recent minutes from the central bank that suggested that policymakers were willing to hike rates as much as needed and were possibly open to a prolonged rate increase cycle.

Inflation in Brazil remains high for now and is only expected to peak later this year. Brazil's annual consumer inflation through April rose to 6.51%, just above the 6.5% upper limit of the government's target band.

But for now policymakers' tougher stance and a slowdown in some pieces of economic data is helping convince investors that the central bank isn't lagging as much as some had worried.

That is making economists more bullish on the prospects for the economy and Brazilian assets.

For much of this year, inflation has been investors' biggest worry in emerging markets. Latin American economies in particular have in the past been badly scorched by periods of hyperinflation that drove prices out of control and eroded the value of their currencies.

In recent days, Brazilian policymakers have struck a confident tone, saying that their rate hikes are working and they have the situation under control. Thursday, the central bank's president, Alexandre Tombini, said annual inflation rate should peak in August thanks to an improving price scenario. Also, recent retail sales data was seen suggesting that spending could be easing a little. Numbers from earlier this month showed retail sales in Brazil climbing a seasonally adjusted 1.2% in March from February, but that was a tick below some analysts had expected.

"There is a perception that the worst is over in terms of overheating," says Carlos Constantini, managing director at Brazilian banking giant Itau. Corporations are now indicating that the peak of the inflationary pressures is behind them, he said.

His firm believes that if the government doesn't introduce drastic measures to curb the currency, investment flows will stay strong and the real could appreciate to as much as BRL1.55 per dollar in 2011. The real briefly neared those levels earlier this year, but then weakened to recently trade near BRL1.6175 per dollar. The decline was prompted by inflation worries and a surge in the cost of borrowing dollars in Brazil, which made the carry trade less appetizing.

Investors also feel that the central bank is more open to currency appreciation as a way of battling inflation. The onshore rate to borrow dollars, which had spiked last month, has since moderated and made the carry trade in Brazil attractive again. Also, the recent drop in commodity prices are also expected to help moderate some of the price pressures for Brazil in coming months.

"Unless we see another significant leg upward in food prices, inflation is going to diminish," says Steffen Reichold, economist at Stone Harbor which invests in emerging markets. "Eventually they will get on top of [inflation]."

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